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This fund, DSP BlackRock ACE Fund Series 2, in terms of strategy is a close cousin of the Kotak India Growth Fund Series 4 which we wrote about here. It will be around for slightly longer (40 months instead of 36 in the case of Kotak) but follows almost the same investment philosophy. That is to buy puts and sell them when the market falls to give higher returns.

In terms of stock selection, the fund will rely on its analysts’ picks whilst adhering to the sector weights of its benchmark Nifty 500 index. The fund will also assign equal weights to all the stocks it picks within a sector. This is where the name comes from – Analysts’ Conviction Equalised or ACE.

Its predecessor, DSP BlackRock A.C.E. Series 1, which is built around the same strategy has given us -3.3% since it was launched in December 2017. This has in fact been lower than the Nifty 500 return despite the market experiencing a major volatility post the Budget 2018. It is, of course, too early to say anything about Series 1.

For those who are new to this type of strategy, here is a quick explanation:

What is a Put?

A put is a right to sell a stock or index at a particular price and protects the buyer from market declines. In return, the buyer pays a premium.

Here’s an example. Say, the fund buys a Nifty 10,600 puts. These will begin earning money as soon as the Nifty falls below 10,600. In return, the fund pays a ‘premium’, a fixed sum of money, rather like the premium you pay on an insurance policy.

When does a ‘Put Strategy’ work?

The premium for a put costs money and will reduce the returns of the fund to some extent. If the market does not decline below the put levels then the premium would be in effect ‘wasted.’

What if the market declines and then goes up? Well, this is precisely the scenario in which the fund proposes to outperform. DSP Blackrock ACE Series 2 will keep selling puts as the market goes to lower and lower levels and ‘cashing in’ on the fall. When the market subsequently rises, it will make money from the recovery and will keep the money from the puts it has sold.

What if the market declines and stays down? In this case, the fund’s puts will mitigate the loss to some extent but not completely.

Here’s an illustration (figures are hypothetical, not actual):

Nifty Level at Fund Inception

Scenario

Performance

10,600

Market declines to 9000 and then recovers to 12,000 after 3 years

Best of Both Worlds: Fund gets the best of both worlds. It gains from the fall by selling its puts and also from the recovery.

Market declines to 9000 and ends at 9000

Overall declines in the fund but better than unhedged: Fund loses money on its equity holdings. However, it makes some money from the puts giving it better returns than an ordinary unhedged equity fund.

Market goes straight up from 10,600 and ends at 14,000

Fund up but worse than unhedged: The fund makes money from the gain in the market but it has in effect ‘wasted’ the premium money on its puts.

RupeeIQ View

Prima facie, the strategy is alluring. Here are a few gaps:

The fund presentation states that puts will be sold when the market falls 10%, 20%, 25% and 30%. It doesn’t expect markets to go down by more than 30% and says that it may not be a suitable option for investors who have this view. This is all very well but markets do not go neatly down and then up. They might fall by 20%, rebound and then again fall by 25%. Will the fund have sold all its puts in the first fall? If yes, the strategy might not shape up. If no, a lot depends on the fund manager’s ability to dynamically use derivatives.

In addition, the fund will aim to book profits at every 12-15% gain in the portfolio and distribute 8-10% of these gains as dividends for investors who opt for the dividend option. However, this may not be very tax efficient after the 10% tax on dividends imposed by Budget 2018.